Chapter five
Using the Accounting Framework: America Online, Inc.
Questions
1.Indicate two possible reasons why a companyÕs total assets would decrease from the beginning of the year to the end of the year.
2.Explain why an increase in an equity account could reflect an increase in assets, but not a decrease.
3.If a company has an account called Òaccumulated deficit,Ó what logical conclusions can you make?
4.If you encounter an unfamiliar account in a companyÕs financial statements, where should you go for further information?
5.What is a deferred cost? Where would it be found in the financial statements?
6.What is the general test for recording a cost as an asset?
7.If it is determined that an asset on the balance sheet has no future benefit, what does proper accounting tell us to do?
8.What does the expression Òtaking a chargeÓ mean when referring to financial statements?
9.Give an expression that would have the same meaning as Òtaking a chargeÓ when referring to a companyÕs financial statements.
10.A companyÕs statement of cash flows begins with ÒNet income.Ó Is the company using the direct or indirect method? Explain.
11.Why are depreciation and amortization expense added back to net income in the statement of cash flows (indirect method)?
12.Why would an increase in prepaid expenses be deducted from net income in the statement of cash flows (indirect method)?
13.Indicate the impact on a companyÕs income statement, balance sheet and cash flow statement of overestimating the useful lives of plant assets.
14.Many airlines have an account on their balance sheets named Òair traffic liability.Ó What does this account represent, and what types of transactions or events would cause this account to increase? When would it decrease?
15.What events will normally increase a companyÕs Retained Earnings account? What events will decrease this account?
16.Give three ways an entityÕs total assets could increase.
17.Give three ways an entityÕs total assets could decrease.
18.Suppose an entityÕs total assets increase because it issues debt. How will this affect the entityÕs income statement, balance sheet and statement of cash flows?
19.Suppose an entityÕs total assets increase because it earns a profit. How will this affect the entityÕs income statement, balance sheet and statement of cash flows?
20.Suppose an entityÕs total assets increase in a year. How should this affect the entityÕs net income in the following year?
21.Everything else constant, will AOLÕs reported income for 1998 be higher or lower because it wrote off its Deferred subscriber acquisition costs in 1997?
22.Suppose AOLÕs Deferred subscriber acquisition costs actually do generate benefits for AOL in 1998. Will AOLÕs net income for 1998 be understated, overstated or properly stated? Justify your answer.
23.Give an example of an asset that you probably would find on the balance sheet of a manufacturing company that you probably would not find on the balance sheet of a consulting firm.
24.Explain how the usage of the asset you named in Question 23 above impacts the income statement of the manufacturing firm.
25.Explain how the acquisition and usage of the asset you named in Question 23 above affects the cash flow statement of the manufacturing firm.
26.For which type of firm is it more likely that inventories and cost of goods sold would be major components of its assets and expenses: large retail grocer or fast food chain? Justify your answer.
27.Everything else equal, would you expect a firm with a lot of competitors or with no competitors to report higher accounting net income? Justify your answer.
28.Comment on the following statement: ÒThe nature of a firmÕs business and its environment are big factors in determining what the firmÕs financial statements look like.Ó
29.Give two reasons shareholdersÕ equity could increase.
30.Give two reasons shareholdersÕ equity could decrease.
31.McDonaldÕs Corp. reported net income of about $1.9 billion for its 1999 fiscal year. Do we know whether McDonaldÕs total assets increased from the end of 1998 to the end of 1999? Justify your answer.
Exercises
In December, 2000, the Financial Accounting Standards Board announced a proposal to change the way companies account for goodwill, an intangible asset. The board is proposing that purchased goodwill, related to acquisitions that have already taken place, would not have to be amortized in future periods. Previously, companies were required to amortize goodwill over a period not to exceed 40 years. Companies would be required to write down purchased goodwill if it was determined that the goodwill had become impaired in value. How will such an accounting change affect a companyÕs income statement and balance sheet compared to the previous regulations?
On February 7, 2001, Cisco Systems announced its second quarter results. Financial analysts were concerned by several aspects of this report: inventories grew by $600 million for the second consecutive quarter, nearly doubling their level from six months before and accounts receivable grew faster than sales during the quarter.
a.What would be some possible explanations for the changes?
b.Why would they concern financial analysts?
The notes to the consolidated financial statements of TJX Companies for the fiscal year ended January 31, 2000, contained the following:
ÒEffective January 31, 1999, the Company changed its method of accounting for layaway sales in compliance with Staff Accounting Bulletin No. 101 ÔRevenue Recognition in Financial Statements,Õ issued by the Securities and Exchange Commission during the fourth quarter of fiscal 2000. Under the new accounting method, the Company will defer recognition of a layaway sale and its related profit to the accounting period when the customer picks up the layaway merchandise. The cumulative effect of this change for periods prior to January 31, 1999 of $5.2 million . . . is shown as the cumulative effect of accounting change in the Consolidated Statements of Income.Ó
a.Explain how the Staff Accounting BulletinÕs regulation better conforms to the revenue recognition criteria of Generally Accepted Accounting Principles.
b.How would this accounting change affect TJXÕs income statement and balance sheet for the current reporting period?
c.Assuming that customers had made deposits on merchandise previously recognized as layaway sales, name the specific accounts on the income statement and balance sheet that would be affected by this accounting change, indicating whether they would increase or decrease as a result of the change. Ignore income tax considerations.
An excerpt from the Wall Street Journal on February 15, 2001 stated:
Viacom Inc. posted a 77% decline in fourth-quarter net income, but the media company, whose holdings include CBS, MTV and Paramount Pictures, made strong gains in its closely watched cash flow. . . . Cash flow . . . leapt in the quarter to $1.36 billion, from $595 million a year ago. . . . Viacom said it anticipates cash-flow growth of 20% this year, to more than $6.2 billion.
Explain how it is possible for a companyÕs income to decline 77 percent while cash flow increases significantly.
For each of the following transactions, events, or facts, indicate the impact on revenues, expenses, income, assets, liabilities, and equity by placing a  or Рsign to indicate direction, in the appropriate box. Write NE for no effect. Be sure to place an answer in every box. Part (a) has been completed as an example.
a.Provided services on account.
RevenuesExpensesIncomeAssetsLiabilitiesEquities
ÂNEÂÂNEÂ
b.Received an advance to provide services in the future.
c.Paid a two-year insurance policy in advance.
d.Paid (in cash) the salaries of employees for current work performed.
e.Amortized intangible assets.
f.Purchased inventory on credit.
g.Sold inventory for cash at a profit.
h.Recognized the expiration of one year of insurance policy purchased in c.
i.Performed a portion of the services that had been provided for in b.
j.Recorded depreciation on plant assets.
k.Accrued wages earned by employees but not yet paid at year-end.
m.Recognized interest expense on a bank loan.
n.Accrued commissions owed to salespeople at year-end.
TransactionRevenuesExpensesIncomeAssetsLiabilitiesEquities
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.
l.
m.
Indicate the impact that each of the following errors or omissions would have on a a companyÕs revenues, expenses, income, assets, liabilities and equities. Place the symbols U = Understate, O = Overstate or NE = No effect in the appropriate box. Part (a) has been completed as an example. Be sure to place an answer in every box.
a.Failed to accrue salaries earned by employees but unpaid at year-end.
RevenuesExpensesIncomeAssetsLiabilitiesEquities
NEUONEUO
b.Understated depreciation expense at year-end.
c.Overestimated the period used to amortize a patent.
d.Failed to accrue revenue earned but not yet recorded.
e.Failed to adjust unearned revenue for services that had been performed.
f.Recorded rent expense in the prepaid rent account.
g.Omitted an invoice for new computers purchased and received at year-end.
h.Omitted an invoice received for electricity at year-end.
i.Failed to make an adjusting entry for insurance expired.
j.Overbilled customers for services provided at year-end.
TransactionRevenuesExpensesIncomeAssetsLiabilitiesEquities
b.
c.
d.
e.
f.
g.
h.
i.
j.
Problems*
AOLÕs Deferred subscriber acquisition costs prior to 1996
The ÒOther assetsÓ section of AOLÕs balance sheets at June 30, 1996 and June 30, 1995 show Deferred subscriber acquisition costs of $314,181,000 and $77,229,000, respectively. The following is excerpted from the ÒCash flow from operating activitiesÓ section of AOLÕs Statements of Cash Flows:
Year ended June 30,
($ in thousands)199619951994
Adjustments to reconcile net income to
net cash (used in) provided by operating
activities
Amortization of deferred subscriber
acquisition costs126,07260,92417,922
Changes in assets and liabilities
Deferred subscriber acquisition costs(363,024)(111,761)(37,424)
a.Show all the activity in the Deferred subscriber acquisition costs from June 30, 1995 to June 30, 1996 in a T-account analogous to the one in Exhibit 5.8.
b.Extend your description of Deferred subscriber acquisition costs to include all activity from June 30, 1994 to June 30, 1995 in a T-account analogous to the one in Exhibit 5.8. (You need to work backwards to calculate the balance of Deferred subscriber acquisition costs at June 30, 1994.)
c.Extend your description of Deferred subscriber acquisition costs to include all activity from June 30, 1993 to June 30, 1994 in a T-account analogous to the one in Exhibit 5.8. (You need to work backwards to calculate the balance of Deferred subscriber acquisition costs at June 30, 1993.)
MicrosoftÕs unearned revenue
The largest liability listed on MicrosoftÕs June 30, 1998 and 1999 balance sheets is Unearned revenue of $2.9 billion and $4.2 billion, respectively. This amount represents cash received from customers that Microsoft will recognize as revenue in future periods. As of June 30, 1998 and 1999, however, Microsoft has declared these amounts as not yet earned, and therefore not yet recognizable as revenue.
a.Suppose Microsoft decides that all amounts in Unearned revenue are earned in fiscal 2000. (That is, the balance in the unearned revenue account is zero at the end of the year.) What effect will this decision have on MicrosoftÕs 2000 income statement, its June 30, 2000 balance sheet, and its 2000 cash flow statement?
b.Suppose Microsoft receives $3.0 billion in fiscal 2000 that it decides is unearned revenue. Also suppose that Microsoft decides that $2.0 billion of the $4.2 billion balance in Unearned revenue at June 30, 1999 has been earned. What effects will these decisions have on MicrosoftÕs June 30, 2000 balance sheet, its income statement for fiscal 2000 and its cash flow statement for fiscal 2000?
An asset impairment occurs when the future cash flows that are expected to be generated by the asset fall short of its book value. An asset that has been impaired must be written down (i.e., its book value must be reduced) to bring its book value into line with the future benefits it will generate. Suppose an asset that has a book value of $10 million is found to be impaired and must be written down to $8 million. The asset has 10 years of life left, and is depreciated on a straight-line basis.
a.What effect will the write down have on the income statement, cash flow statement, and ending balance sheet in the year the write down occurs?
b.What effect will the write down have on the income statements, cash flow statements, and ending balance sheets in the years after the write down, but before the asset is retired?
c.What effect will the write down have on the income statements, cash flow statements, and ending balance sheets in the years after the asset has been retired?
In the United States, research and development (R&D) costs generally are not recognized as assets; that is, they are expensed as incurred. Suppose a corporation incurs $50 million of R&D costs in its first year of operation. These expenditures will generate cash flows over the next 10 years.
a.In comparison to capitalization of the costs of R&D, how does the requirement that R&D costs be expensed as incurred affect the income statement, balance sheet, and cash flow statement of the company in the first year of the companyÕs life?
b.How does the requirement that R&D costs be expensed as incurred affect the income statement, balance sheet, and cash flow statement of the company in the next 10 years of the companyÕs life? Assume that no further R&D expenditures are made after the first year.
When one company buys another, GAAP require that the identifiable assets of the acquired company be written up to their fair market value, as long as the written up total book value of the company does not exceed the price paid for it. In the Ònew economyÓ companies are often acquired for their intellectual property, which often includes projects at various stages of development. A common practice in the 1990Õs was to write off large amounts of the purchase price of acquired companies as being related to Òin-process R&D.Ó That is, the acquiring company would take a write off in the amount of this R&D in the year the company was acquired.
a.What is the effect of the write off of in-process R&D on the acquiring firmÕs income statement, ending balance sheet and cash flow statement in the year of the write off?
b.What is the effect of the write off of in-process R&D on the acquiring firmÕs income statement, ending balance sheet and cash flow statement in the year after the write off?
c.Why would an acquiring firm want to write off in-process R&D?
d.Why would the United States SEC require more than 50 companies to reduce their write offs of in-process R&D?
A company planning to restructure its operations that meets certain formal requirements is allowed to accrue expected costs in the year the restructuring plan is adopted. That is, the company is allowed recognize expected restructuring costs by setting up a liability. Suppose restructuring costs are estimated to be $100 million.
a.Give the entry required to recognize the expected restructuring costs.
b.How would recognition of these costs affect the income statement, ending balance sheet, and cash flow statement in the period in which this recognition occurs?
c.How would recognition of these costs affect the income statement, ending balance sheet, and cash flow statement in the periods in which this restructuring actually takes place? Assume that actual restructuring costs are exactly as expected.
d.Why might a company intentionally overestimate restructuring costs?
Leslie Fay once had a problem with failure to recognize returns of merchandise from stores. When the merchandise was shipped to distributors, it was recorded as a sale on account. When it was returned, the item was placed back in inventory (no journal entry was made), but the sale and the receivable remained on the books. Further, inventory was taken periodically, so the merchandise was counted as being in ending inventory (i.e., Leslie Fay computed the cost of goods sold by taking the beginning-of-the-year inventory value, adding purchases made throughout the year, and subtracting the value of the ending inventory obtained through a physical count at year-end).
a.Assume all these problems occurred in one fiscal year. What effects did the failure to account properly for returns have on Leslie FayÕs ending balance sheet, income statement and cash flow statement in the year of the fraud?
b.A common method of committing financial reporting fraud is to continue to recognize sales for a few days after the end of the reporting period. Mechanically, this is accomplished by holding open the sales and cost of goods sold accounts when they should have been closed. What effects does this technique have on the income statement and ending balance sheet in the first year it is done?
c.What effects does this technique have on the income statement and ending balance sheet in the year following the year in which it is done?
The New York Times reported on February 3, 2001 that the high-tech company Critical Path had suspended two executives and began a investigation into its own financial practices. Critical Path supplies systems that support corporate e-mail, and had recently reported disappointing earnings. The company had blamed its disappointing results in part on its auditors, PricewaterhouseCoopers, who insisted that Critical Path change its accounting for $7 million of licensing fees. The licensing fee entitles the purchaser of the license to the use of the software and to support over several accounting periods. Critical Path had counted the $7 million as Revenue. PricewaterhouseCoopers thought the $7 million was Unearned revenue that should be recognized as revenues over several subsequent periods. Before the disallowed revenues, Critical Path had reported revenues of $52 million.